It’s Not What’s Possible That Counts

Story Highlights:

• A major earthquake struck Japan on Friday, causing a tsunami and leaving destruction in its wake.
• More quietly, the much-discussed Saudi “Day of Rage” came and went with little rage.
• Both events highlight a central point: While it’s perfectly fine to consider the probability of a negative event happening, investing solely on the possibility is erroneous.

Friday’s headlines were dominated by coverage of a massive earthquake that struck northern Japan. The quake was the largest in recorded Japanese history—8.9 on the Richter scale and triggering a 30-foot tall wall of water that rushed ashore. This is a tragedy with both a human and an economic toll. It’s perfectly right and natural to feel for the victims of events like this, but when assessing the capital markets impact, it’s critical to recall stocks just don’t think about disasters the same way humans do.

Consider that in 2004, much of the coastline of many countries bordering the Indian Ocean was devastated by a tsunami generated by a massive undersea earthquake. Hundreds of thousands lost their lives in an unmitigated tragedy of extreme proportions. But note: From an economic perspective, even countries that took a direct hit didn’t fall into a long-term economic quagmire. And the impact on global stocks was even less. While natural disasters like Friday’s earthquake are always possible, they tend not to spook markets much or for very long. A lesson taught again Friday, when US stocks rose as details of the earthquake were still emerging.

Much more quietly, another story driving up investors’ blood pressure lately came to a head. Since a Tunisian fruit merchant set himself ablaze weeks ago, folks have feared an unrest contagion spreading throughout the Middle East—in particular, to oil-rich Saudi Arabia. And folks, that’s possible—unrest and revolution always are, especially in hard-line autocratic nations where freedom is questionable. So in recent days, when reports emerged of a planned Saudi “Day of Rage” protest scheduled for March 11^th, some investors’ minds immediately went to thoughts of possible spiking oil prices resulting in possible economic woes from possible unrest that factual economic plans to dispel could possibly fail to forestall. Friday, a few hundred people protested. We’re sure they were mad, but it seems the “Day of Rage” was lacking in much rage. (To help scale this, that’s about 2%-5% of the average number of angry people attending Pittsburgh Pirates home games.) It’s also possible that if Libyan dictator Muammar Gadhafi had chosen a different response to unrest (maybe the Saudi/Kuwaiti model of giving money and/or food instead of Gadhafi’s crimes against humanity), there wouldn’t be Libyan conflict today. Now, is it possible protests grow moving forward? Yes. But that’s not the right question for investors to ask.

Negative events like earthquakes and unrest in pockets of the world are always possible (they’re not super surprising, wildly unpredictable black swans so much as they are gray pigeons—seen occasionally, but regularly over time). What these two stories highlight for investors is making decisions to plan for all possibilities without scaling and assessing shifting probabilities is simply an erroneous investing practice that might result in the occasional near-term success but probably leads to far more failures. Correct forward-looking decisions should be based on an assessment of the long-term probabilities—scaling, weighing positives and negatives, and removing emotion from assessment. This is what most people do in everyday life! It’s possible you could break a leg stepping out your front door or expose yourself to methane gas sitting on your couch (or that the Mayans were right and 2012 is the end—but we doubt it). That being the case, you might watch your step, but it’s unlikely to stop you from walking altogether. While it’s fine for investors to assess the probability of risks, just as you can’t live life eliminating all possibility of negative events, you can’t invest to remove all possibility some negative event happens.